Economy · June 23, 2022

Bad explanations for inflation | AIER

While breaking down inflation into its constituent parts is empirically complicated, its essence is simple. Inflation is the result of too much money chasing too few assets. Milton Friedman popularized this rule of thumb. Its combination of intelligibility and explanatory power explains why it is still widely used.

But not everyone got the memo. Very Online ™ politicians, bureaucrats, journalists and academics are looking for other causes. Let’s consider some bad explanations for inflation.

“Greedy corporations!”

A favorite of progressives in Congress, especially Senator Elizabeth Warren, this explanation is the worst of the lot. Corporations are always greedy. They want the profits to be as large as possible. Yet inflation is rarely as high as it is now. The last time we saw the dollar depreciate so quickly was 40 years ago. It is not possible to explain a variable effect with a constant cause. Gravity does not cause you to stumble and fall. Greed does not cause inflation.

“Market power!”

In economics, “market power” means the ability of firms to charge prices above marginal costs. Proponents of market power explanations for inflation point to greater concentration in several sectors over the past two years.

For the sake of argument, suppose that the concentration of industry has increased. It still doesn’t explain inflation.

First, the link between concentration and market power is weak. Sometimes the concentration is driven by structural economic factors, an efficient response to changing economic circumstances. When this happens, there is no corresponding increase in market power.

Second, the market power argument confuses the level of prices for the Rate of growth of prices. Inflation refers to the latter. Even if market power allowed companies to raise prices, it would be a one-time event. Inflation would rise temporarily, and then return to the trend. Instead, we had a long period of above-trend inflation. It just doesn’t come back.

“Wage Price Spiral!”

Some bad explanations never die. The wage spiral view was a pillar of Keynesian (pseudo) inflation theories from the mid to late 20th century. It was bad then and it’s bad now.

Presumably, rising prices cause workers to demand higher wages, which results in companies charging even higher prices to break even. It’s a positive feedback loop. But it has two serious flaws. One is conceptual. The other is real.

Conceptually, it makes no sense for wages to exceed worker productivity. Companies cannot afford to pay workers more than the value those workers add to the company’s profits. If you own a sandwich shop and think hiring a potential worker would add $ 15 per hour of revenue, what is the maximum amount you’d be willing to pay them to work? You will lose money if you pay it more than $ 15 per hour. The dollar figure of the worker’s output, what economists call the product of the marginal revenue from laboris the upper limit of the bets.

Indeed, inflation has outpaced wage growth for months. The CPI rose 8.6% yoy, while nominal (dollar value) wages rose only 5%. This means that workers have actually taken a pay cut (i.e., after adjusting their wages for inflation). Which wage-price spiral? If anything, the companies are getting a deal!

“Push the costs!”

I’ll accept begging for $ 400, Alex! This inflation theory states that firms pass (“push”) higher costs onto consumers in the form of higher prices. But this is not an explanation. He’s just repeating the thing to explain. Why are the costs increasing? You are back to where you started.

Improve public discourse

Hopefully, these bad explanations will soon fade from public consciousness. We need to focus on what matters: a comparative abundance of money versus goods. To be clear, this does not mean that inflation is 100% driven by the money supply. I am sure that the persistent supply chain problems from the pandemic and the ongoing war in Ukraine are part of the problem. Furthermore, we should be careful in weighing monetary versus non-monetary factors.

My colleagues at the Sound Money Project have done a good job (here, here, here, here and here most recently) showing that money matters a lot right now. It is not the whole explanation, but it is the larger part. Armed with this knowledge and vaccinated against some of the foolish explanations being spread today, we can work to find political solutions to regain control over the value of the dollar.

Alexander William Salter

Alexander W. Salter

Alexander William Salter is Georgie G. Snyder Associate Professor of Economics at Rawls College of Business and Comparative Economics Research Fellow at the Free Market Institute, both at Texas Tech University. He is co-author of Money and the rule of law: generality and predictability in monetary institutions, published by Cambridge University Press. In addition to his numerous academic articles, he has published nearly 300 opinion articles in major national newspapers such as the Wall Street newspaper, National Review, Fox News opinionAnd The hill.

Salter received his Masters and Ph.D. in Economics from George Mason University and a BA in Economics from Occidental College. She participated in the AIER Summer Fellowship program in 2011.

Receive notifications on new articles by Alexander William Salter and AIER.